Olivier Blanchard’s second thoughts

5 October, 2016 at 18:01 | Posted in Economics | 4 Comments

Olivier Blanchard has had some Further Thoughts on DSGE Models and now comes up with the view that

1643-lebowski-jpg-610x0Macroeconomics is about general equilibrium …

The specific role of DSGEs in the panoply of general equilibrium models is to provide a basic macroeconomic Meccano set, i.e. a formal, analytical platform for discussion and integration of new elements …

The only way in which DSGEs can play this role is if they are built on explicit micro foundations.

Well, if Blanchard were right on this, then economics is really in serious troubles.

Rather than being necessary requisites for progress, general equilibrium and microfoundations are the main barriers to progress in macroeconomics!

Almost a century and a half after Léon Walras founded general equilibrium theory, economists still have not been able to show that markets lead economies to equilibria. We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient. But one has to ask oneself — what good does that do?

As long as we cannot show that there are convincing reasons to suppose there are forces which lead economies to equilibria — the value of general equilibrium theory is nil. As long as we cannot really demonstrate that there are forces operating — under reasonable, relevant and at least mildly realistic conditions — at moving markets to equilibria, there cannot really be any sustainable reason for anyone to pay any interest or attention to this theory.

A stability that can only be proved by assuming Santa Claus conditions is of no avail. Most people do not believe in Santa Claus anymore. And for good reasons. Santa Claus is for kids. And real scientists are grown-ups.

Continuing to model a world full of agents behaving as economists — “often wrong, but never uncertain” — and still not being able to show that the system under reasonable assumptions converges to equilibrium (or simply assume the problem away), is a gross misallocation of intellectual resources and time.

And then, of course, there is Sonnenschein-Mantel-Debreu!

Sonnenschein-Mantel-Debreu ultimately explains why “modern neoclassical economics”  with its microfounded DSGE macromodels are such bad substitutes for real macroeconomic analysis.

These models try to describe and analyze complex and heterogeneous real economies with a single rational-expectations-robot-imitation-representative-agent. That is, with something that has absolutely nothing to do with reality. And — worse still — something that is not even amenable to the kind of general equilibrium analysis that they are thought to give a foundation for, since Hugo Sonnenschein (1972) , Rolf Mantel (1976) and Gerard Debreu (1974) unequivocally showed that there did not exist any condition by which assumptions on individuals would guarantee neither stability nor uniqueness of the equlibrium solution.

Opting for cloned representative agents that are all identical is of course not a real solution to the fallacy of composition that the Sonnenschein-Mantel-Debreu theorem points to. Representative agent models are rather an evasion whereby issues of distribution, coordination, heterogeneity — everything that really defines macroeconomics — are swept under the rug.

Microfoundations – and a fortiori rational expectations and representative agents – serve a particular theoretical purpose. And as the history of macroeconomics during the last thirty years has shown, this Lakatosian microfoundation programme for macroeconomics is only methodologically consistent within the framework of a (deterministic or stochastic) general equilibrium analysis. In no other context has it been possible to incorporate these kind of microfoundations, with its “forward-looking optimizing individuals,” into macroeconomic models.

This is of course not by accident. General equilibrium theory is basically nothing else than an endeavour to consistently generalize the microeconomics of individuals and firms on to the macroeconomic level of aggregates.

But it obviously doesn’t work!

The analogy between microeconomic behaviour and macroeconomic behaviour is misplaced. Empirically, science-theoretically and methodologically, neoclassical microfoundations for macroeconomics are defective. Tenable foundations for macroeconomics really have to be sought for elsewhere.

Instead of basing macroeconomics on unreal and unwarranted generalizations of microeconomic behaviour and relations, it is far better to accept the ontological fact that the future to a large extent is uncertain, and rather conduct macroeconomics on this fact of reality.

The real macroeconomic challenge is to accept uncertainty and still try to explain why economic transactions take place – instead of simply conjuring the problem away by assuming uncertainty to be reducible to stochastic risk. That is scientific cheating. And it has been going on for too long now.

The sooner we are intellectually honest and ready to admit that the microfoundationalist programme has come to way’s end – the sooner we can redirect are aspirations and knowledge in more fruitful endeavours.

microfoundations3The main fallacy in this kind of thinking is that the reductionist hypothesis does not by any means imply a “constructionist” one: The ability to reduce everything to simple fundamental laws does not imply the ability to start from those laws and reconstruct the universe … At each stage entirely new laws, concepts, and generalizations are necessary, requiring inspiration and creativity to just as great a degree as in the previous one …

In closing I offer two examples from economics of what I hope to have said. Marx said that quantitative differences become qualitative ones, but a dialogue in Paris in the 1920’s sums it up even more clearly:

FITZGERALD: The rich are different from us.

HEMINGWAY: Yes, they have more money.

 P.W. Anderson  (Nobel Prize winner in physics 1977)




  1. I long for the day when economists of Blanchard think first of the actual economy. The first question should be, what is the economy? Is the economy a system of markets? Is the economy a system of markets seeking a general equilibrium in prices? I would think the answer, based on observation and reasonable rules of interpretation of observation would have to be, “no, the economy is not primarily or predominantly a system of markets nor is the economy seeking a general equilibrium in price.”
    Perhaps it will seem odd that I do not hold that GE analysis is completely useless. Obviously, any claims of isomorphism between such analytic models and the actual economy are specious, even if the theorist were to stupid to understand that the a priori nature of analysis precludes descriptive claims. But I do hold that GE theories can help us to understand what we need to look for in the actual economy, as long as we understand that we cannot expect to find the impossible things of our theoretical dreamscape. The actual economy must have at least partially successful methods and mechanisms to cope with uncertainty.
    The imperative ought to be go and look.

  2. While of course broadly agreeing with Lars and Bruce (and I can’t support enough the “go and look” imperative), I am even more sceptical.
    What exactly does it mean to say that …?

    We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient.

    What does “exist” mean here? (Even) when qualified by “under very restrictive assumptions”?
    Bruce, what exactly is it that GET helps us understand that we need to look for in the actual economy, and how exactly does it show us that?

    • Going way back to Arrow, DeBreu, McKenzie, one takeaway might be that a competitive market economy under uncertainty requires a lot of insurance to be efficient. Distributing decision making requires distributing income (rewards) and risk from outcomes. Without insurance and warranties against the possibility of adverse outcomes, agents must be either reckless or risk-averse in their decision-making. In the simple setup of Arrow DeBreu, we want agents to treat expected value as a sufficient statistic for decision-making and that requires sufficient insurance to make the realization from outcomes equivalent to a certainty. The setup is a descriptive absurdity, as is the Euclidean Flatland of plane geometry, but the basic insight into the incentive problem for distributed decision-making is valuable and ought to make economists curious about how the institutions of the actual economy go about handling hedges, contingencies, insurance et cetera. Arrow himself said as much back in the day and economists like Oliver Williamson invoke that inspiration. (Macro seems to forget all that, though, including the absurdities of using analytic models descriptively.)
      Somewhere, Axel Leijonhufvud comments that rational expectations could be interpreted as informationally efficient financial markets operating so perfectly that agents prefer to act as if the prices given by financial markets are equivalent to objective facts, regardless of their own private information. If you like, agent participation in financial markets effectively albeit implicitly reveals all private information including models. It seems to me that ought to lead to curiosity about the implications of actual financial markets being somewhat inefficient: we can observe some “outsiders” treat market prices and auxiliary information such as ratings (AAA bond) as objective facts, stocking insurance company portfolios according to rules, even while “insiders” actively use private information in arbitrage. Economists ought to be interested in how far the insiders can deviate from the outsiders, how practically inefficient financial institutions can be, before trouble ensues.

  3. “Different types of general equilibrium models are needed for different purposes. For exploration and pedagogy, the criterion should be transparency and simplicity, and for that, toy models are the right vehicles.”

    It is hard to understand why these people can’t see what is wrong with this. It’s farce beyond any imaginable parody.

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